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Thursday, December 15, 2011

Stop me if you've heard this one

Fascinating stuff passed along by a colleague in the tax professor world:

It is a slow day in a little Greek village. The rain is beating down and the streets are deserted. Times are tough, everybody is in debt, and everybody lives on credit. On this particular day a rich German tourist is driving through the village, stops at the local hotel and lays a €100 note on the desk, telling the hotel owner he wants to inspect the rooms upstairs in order to pick one to spend the night.

The owner gives him some keys and, as soon as the visitor has walked upstairs, the hotelier grabs the €100 note and runs next door to pay his debt to the butcher. The butcher takes the €100 note and runs down the street to repay his debt to the pig farmer. The pig farmer takes the €100 note and heads off to pay his bill at the supplier of feed and fuel.

The guy at the Farmers' Co-op takes the €100 note and runs to pay his drinks bill at the taverna. The publican slips the money along to the local prostitute drinking at the bar, who has also been facing hard times and has had to offer him "services" on credit. The hooker then rushes to the hotel and pays off her room bill to the hotel owner with the €100 note.

The hotel proprietor then places the €100 note back on the counter so the rich traveler will not suspect anything. At that moment the traveler comes down the stairs, picks up the €100 note, states that the rooms are not satisfactory, pockets the money, and leaves town.

No one produced anything. No one earned anything. However, the whole village is now out of debt and looking to the future with a lot more optimism. And that, ladies and gentlemen, is how the bailout package works!

Comments (30)

You had me until the last line. If only that were true!

In a year or two the German tourist will drop 100 DM on the counter and the hotelier can use it to pay off his 20 zillion Drachma debt.

By the way, we can ask John Corzine how optimistic he's feeling these days, because this is pretty much what happened at MF Global, except account holders (the tourist in the allegory) never got their deposits back.

okay - I'm an idiot -- someone explain to me why this doesn't work? I know it doesn't, but I can't articulate why...

Nor is it particularly accurate to say that nothing was produced: The hotelier produced some meals with raw materials from the pig farmer; the farmer in turn produced the bacon, chops and what have you with product from the feed supplier, who has very likely contributed in that same fashion to the nourishment of several other townspeople during the day. It might be a fair assumption that some of the grain also turned into potables and snacks at the pub.

That's how economies work.

Now, what happens if the hotelier instead deposits the money with a distant bank, which in turn uses it to wager that hog futures in Uruguay will rise at some point during the following year? That's where the train of productivity jumps the tracks.

Of course it works. And of course it doesn't, in the real world. Why? Because in all those transfers of money people take a cut for the xfer itself. Because all those transfers rely on a strict order, and if one person in the line gives the money to someone not in the line the game is over. Because everyone doesn't owe the same amount, so the 'seed money' needs to be huge to total more than any individual. Because even if folks are trustworthy, some aren't, and money has a tendency to bring that out. One slip and poof... it's gone. (I'm sure there are other reasons.)

It's where the saying "bag holder" came from; even if you're upstanding but the guy in front of you isn't, you're left holding an empty bag.

And in the story the German is potentially the ultimate bag holder - it's ALL got to go right or, Thank You For Your Donation, Herr von Shtump!

"Nor is it particularly accurate to say that nothing was produced..."

Respectfully, it is accurate to say nothing was produced from THAT 100 Euro. It's the insideousness of debt - paying it off doesn't produce anything, because what's being paid off is historical production, not current production.

It's how debt crisis happen - debt (say, accounts recievables) are used as "money" to finance more debt (borrowing against what I will be paid for past production). Taken to extremes by our big-brained financial Masters of the Universe and their "financial innovations" we end up where we are today; multi-layers deep in leverage, where one player saying "uh... don't have the cash for that..." and poof! Lot's of folks have lost what they were sure was "their" risk-free money.

I agree with Roger.
Items were produced and sold. Services were rendered, and everyone got paid. It's unlikely that a German would loan you money for free...but thats another story.

The tale depends upon the 100 remaining intact as if all of the debts were bartered away and everyone was in a closed circle of commerce.

It's a lovely fantasy though. Much like the TriMet, Metro & UR fantasies.

Spend a billion.
That triggers billions in development.
That produces a billion in revenue.

It was all free!

NOTHING "new" was produced; it was all produced in the past and paid for with "debt". When each person passed on the same amount of many to pay off their "old" debt, nobody made a profit so at the end of the day, nobody had any available cash to finance the next production. So, they all went into debt again. If the tourist was lucky, the tourist received his money back; if not, he was was the loser.

It seems so easy, but anybody producing wealth or buying/selling wealth knows it's a scam.

I might be wrong about this but... isn't the hotel proprietor out $100? He provided services to the hooker then gave the $100 payment to the tourist without anything in return. So, he's still short $100 on his balance sheet.

I guess, then, the hotel owner represents the taxpayer...

"hotelier grabs the €100 note and runs next door to pay his debt to the butcher."

He no longer owes the butcher.

Ben: right you are.

"okay - I'm an idiot -- someone explain to me why this doesn't work?"

Because the hotel guy received 100 to pay off the pro's bill, that he could've put into the bank, but gave it back to the German and won't see it again.

The German injected 100 into the system and then took out a 100, except now the hotel guy is missing the money.

Only Dennis found the wealth creation but mistakenly thought Roger was right. The only creation of $100 was the "whore services" and this is the joke.

"except now the hotel guy is missing the money."

Yes but he doesn't owe the butcher any more.

""hotelier grabs the €100 note and runs next door to pay his debt to the butcher."

He no longer owes the butcher.

True. Let's make is simpler though to show how nothing is truly produced.

Say the butcher also owes the hotelier €100 (simply making the circle very small). He hands it back to the hotelier, the German takes it and leaves.

The hotelier did not eat today, because he used the money to pay for what he ate in the past instead. The Butcher doesn't have a place to stay today, because he used his money to pay for the bed in the past.

True, both are out of debt. But there has been nothing produced with the capital today. So the state of play is both are in same situation they were in before, simply out of debt.

And most importantly the capital can't be used in the future to produce, because Herr has skeedadled back to the Fatherland.

So, the butcher will sleep in the rain tonight. And the hotelier will go hungry today. Both can work today, going without, and get "back on their feet" by having something after that work. But that loss, that day and its work, in essence "paid" the debt for both. Welcome to austerity! (Or they will borrow... again, instead of going without.)

Debt will be paid with REAL production in the future (unless it is just welched on/forgiven). Money tricks (even ignoring all the pragmatic reasons listed above) simply cannot change that fact.

Before anyone drives their SUV through the gaping hole in my argument I'll overturn it myself. And I thought I was being so smart.

Hit enter, and realized the I could argue against what I typed – the German money is input into a state where the players are NOT broke, so they won't go hungry, get wet, etc.

It's actually a big assumption – in the US everyone's heard that 40 cents of every dollar spent by the fed gov is borrowed – but lets take it that that is the case. All that's needed is an input of cash, debts are gone, and everyone is making what they need.

With that there really is no problem with it – it will work in the story, given those parameters.

But notice, it's exactly the same as everyone simply forgiving everyone else's debt. Exactly. Simply trace the circle big enough and make all the links and at the same moment everyone says “You're debt is forgiven!”

In the real world that doesn't happen. And when it does, say under a King, someone ends up holding the bag – having less than they thought they did when all is forgiven.

In the same way, for all the reasons listed and more, the German and his C note doesn't happen in the real world. The scenario is an example of “if we were just organized enough everything would be alright!' thinking. Enticing in theory but very bad in reality when tried.

It never works out like they think it will.

okay - I'm an idiot -- someone explain to me why this doesn't work? I know it doesn't, but I can't articulate why...

It works in this special case because there is a circular collection of perfectly offsetting debts. A simpler example would be if the proprietor and the butcher each owed the other 100 Euros -- each could and likely would agree to cancel the others debt without any money changing hands. The same thing is happening with this totally unrealistic, never happens in the real world example, with the 100 Euros acting as the currency of debt cancellation among the parties.

Hey Roger, what more can you tell us about those Uruguayan hog futures?

Jack- please ask the colleague in the tax professor world what his take is on all these answers (theories) and what his answer might be in terms of our economy today? Would any or all of the answers collectively mentioned above deserve a passing grade in his "Tax 101" class? Please also ask him if he is willing to respond to try and put his answers into layman speak.

The reality is not so simple. The hotel owner has sold puts on the prostitute, for fear of her turning old. The prostitute, in turn, has bought calls on a new hotel development down the street. And, meanwhile, that German isn't using his own money... he's getting financed, one way or another, by MF Global, who are (illegally) borrowing against futures contracts for USA ranchers hedging against grain downturns.

It doesn't work because no German would ever leave a 100 eu note with a Greek.

There's a lot of missing information here. For instance - how big are the prostitute's cans?

Yes but he doesn't owe the butcher any more.

Same thing would've happened if the butcher would've accepted the IOU from the pro instead of legal tender.

Actually though, this works better since the guy in the street is seeing a diff.

Right now, we are dumping buckets of money into the system (banks), but the only thing they are buying is stuff they can sell tomorrow (like stocks, gold, oil, commodities, etc.) instead of long-term investments which would help the small guy.

There's one thing being missed here: Everyone in the loop feels better after the debt is retired, and given their tolerance for going into debt was apparently 100 EU, they can now continue their consumption binge, up to this level, driving more GDP production for Greece.

But it's only a feeling; nothing substantial has changed.

And what about the Greek income tax imposed on the 100 EU gross income that everyone enjoyed? (And yes, I'll acknowledge that honest reporting of these cash transactions is an even more theoretical construction than the original story itself).

From a balance sheet perspective, everyone remains the same. They all reduced their debt by $100 and the amount owed to them by $100. No one is better off, although it is likely they had discounted their expected value of the debt they held, but then again the holders of their debt did the same thing.

I believe Newleaf's initial comment on the future DM to Drachma exchange rate is likely correct, and the German got screwed in the transaction.

As to John Rettig's comment about tax reporting in Greece, I recently read that there are more Porsche Cayannes registered in Greece than households reporting over $50,000 in income.

This is also the notion of "netting" in derivatives. There is something like $600 trillion in gross notational derivatives outstanding. If two counterparties held offsetting positions, they could just agree to close the trades with one another and all would be well.

This is one of the discussions in the EU right now - figuring out who owes what to whom, and negotiating to close as many oepn trades as possible to simplify the eventual bailout. The trick is, once everyone exposes their holdings, those in weaker positions lose power.

If everyone is out of debt when the German leaves, doesn't this create a situation where - to use the shortened version - the hotelier can provider a room to the butcher in exchange for a pork chop dinner? Both sides (and presumably all of the other players) get something of value that meets their needs.

Why doesn't this work?


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